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30/01/2018 | Geopolitics Has Caused the Oil Price Rally

Todd Royal

The Wall Street Journal recently published an article titled: “Five Potential Risks to the Oil Rally,” that details how geopolitics is one of the leading reasons Brent crude is on the upswing; many analysts though believe oil is overpriced. The rally has many optimistic, particularly after a Goldman Sachs conference January 10-11 in Miami where shale drillers said they would exercise discipline, and not drill excessively, thus lowering returns to investors and shareholders.


But that narrative counters the Energy Information Administration (EIA) announcement in early January stating the reasonable expectation of U.S. oil production topping 11 million barrels by the fourth quarter of 2019. The EIA also raised its forecast for U.S. production to 10.3 million bpd, 300,000 barrels a day higher than it forecasted in December 2017.

Shale production exceeded the original EIA estimate of 9.3 million bpd by 11% in 2017. Those numbers alone should have market watchers questioning this rally, plus recent U.S. tax law changes that benefit energy companies. Only a shortage of shale workers could stop their production gains, which remains a real possibility.

Demand for oil is strong, because of cold winter months, strong economic growth from China, India, and the U.S. – and a weaker US dollar. But with OPEC concerned that higher oil prices will lead to increased shale production, it seems reasonable that shale production will counter higher prices. That is unless geopolitics continues to overtake economic reason.

This rally seems heavily predicated on the speculative, ever-changing nature of geopolitics, yet there are real concerns warranting attention that could cause oil price fluctuation. India has successfully tested a ballistic missile that worries China. Fighting continues in Syria. China and the U.S. could engage in a devastating trade war in 2018 over China’s trade surplus. North Korea’s nuclear problems persist. And Russia and Ukraine are still engaged in conflict over eastern Ukraine after Russia annexed Crimea in 2014.

The Middle East is split into geopolitical factions, where most Sunni nations fear Shia Iran’s nuclear ambitions. Adding some geopolitical levity to the dangerous Iran-Saudi rivalry, Hans van Cleef, energy economist at ABN Amro said, “An escalation [in Saudi Arabia or Iran], in which also oil production would be hit, seems unlikely because of strong mutual economic interests.”

While the specter of war is a real possibility that could disrupt oil supplies, the rational actor model in international relations and the U.S. being one of the largest fossil-fuel energy producers in the world, negate the geopolitical aspects of the rally currently taking place.

The rational actor model comes from “rational choice theory,” and posits a nation-state makes rational decisions based on: “goal setting/ranking, options, consequences and profit-maximization.” As an example – Shia Iran versus Sunni Saudi Arabia – have too much to lose economically and socially by reverting to total war against one another. They have options, (use proxies to fight each other), can assess consequences (war means U.S. increases market share over OPEC), and profit maximization loss (long-term struggle leads to regime instability through economic hardship).

Putting the theory to the test, North Korea is seen as an unstable, hair-trigger foe ready to launch nuclear missiles at the U.S., Japan, South Korea, et al. Each missile test the North Korean regime launches can send oil pricesupward, causing the market to behave irrationally.

Current CIA Director, Mike Pompeo, sees the situation in North Korea differently and in a way that could have a profound effect on oil prices long-term. Director Pompeo believes Kim Jong-un of North Korea can be planned for and dealt with on the international stage and through negotiations, stating: “We in the intelligence community…have said that Kim Jong Un is rational.” Of course totalitarian war-seekers can use provocative behavior against their neighbors, but that doesn’t necessarily mean rational models of decision-making don’t hold true. Geopolitics, outside of interstate war, just isn’t a valid reason for prices to keep moving on their upward trajectory.

Moreover, the world community may not like Kim, Putin, or Assad, but intelligence agencies, militaries, and governments can make rational decisions as to how they will act. Oil prices rising and falling off the actions of these states are why analysts like Richard McGuire of Rabobank strategists tell Bloomberg: “We could argue that an ongoing rise in oil prices provides an important explanatory factor regarding the rise in long-end yields this week and in recent month.”

Bond yields rising with higher oil prices based on the specter of war between Iran and Saudi Arabia via the troubles taking place in Yemen is devastating regionally, but it won’t affect the global economy, oil supplies, or demand since both countries have rational reasons for not wanting an all-out war.

There are some valid reasons for oil prices to increase. Venezuela’s oil industry and production “collapsing” is an economically sound reason based on supply and demand for oil prices to rise; not the bluster of immature leaders. The oil price rally will continue based off of supply taken off the market and storage being drawn down. Geopolitical anxieties will subside and nervous investors shouldn’t let developments across the globe reported on immediately in our 24/7 news cycle disrupt sound investment strategies.

The opinions, beliefs, and viewpoints expressed by the authors are theirs alone and don’t reflect any official position of (Canada)


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